Fooled by Conviction: The pitfalls of “high conviction” investing

Active management is intrinsically difficult. The tendency of most active managers to under perform passive benchmarks has, if anything, grown in recent years, and this has led some observers to advocate that active managers should become more aggressive and operate more concentrated portfolios. A manager who chooses to concentrate can only hope to improve his results if he has a particular type of skill, and this skill must be quite rare. If this were not so, active funds would not be facing a performance challenge in the first place. For the industry as a whole, higher concentration levels may raise active risk, make skill harder to detect, increase costs, and reduce the number of outperforming funds. Furthermore, it may confuse, rather than clarify, the interaction of asset owners and asset managers. The challenge for an asset owner is to distinguish genuine skill from good luck. The challenge for a manager with genuine skill is to demonstrate that skill to his clients.

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